Many investors don't understand retirement savings rules, and it costs them

"I'm getting a small tax refund this year, and then there's the economic stimulus money," she wrote in an email, "but I don't think it's anywhere near the $4,000 I'm supposed to put in there, and I don't think I can come up with the rest of the money right now."

It took me a little while to figure out precisely what she was talking about, until it dawned on me that she was the personification of a recent AARP Financial survey showing that an alarming number of American savers don't understand how individual retirement accounts work.

In Patricia's case, as it turns out, she had heard about the ability to set aside up to $4,000 and thought that was the amount she had to save. Failing to achieve that amount, she figured that the benefits of an IRA were off-limits to her.

"A lot of people don't even think about an IRA all year," said Ed Slott, the founder of IRAhelp.com and author of "Your Complete Retirement Planning Road Map."

"Then they get to this time of year -- their last chance to contribute for the prior year, but also when they get their tax refund -- and they're told they can put $4,000 into it, and they don't have that kind of money lying around so they don't participate," he added.

"They think it's all or nothing, which never was the case," he said, "or they don't think that setting aside a little bit of that amount will ever amount to anything, when some savings is better than none."

Patricia's misunderstandings about the IRA system are far from unusual.

The AARP Financial survey found that 44% of Americans say they don't understand how an IRA works. That number goes up to half of people aged 18 to 49, the prime age range for people looking to get a jumpstart on retirement savings.

Further, the survey discovered that 55% of the respondents did not know the difference between a traditional IRA and a Roth IRA (the latter uses after-tax money and grows tax-free for life), while two-thirds of respondents did not know that contribution limits go up for people aged 50 and over.

Knowing how IRAs work does not guarantee participation. The study of more than 1,200 adults found that 71% of those surveyed believe that an IRA is "worth the bother," but just under 40% of respondents actually have bothered to open an account. That's not entirely surprising, since nearly the same percentage of respondents said they're unsure or don't know if they're even eligible to contribute to an IRA. (Eligibility rules depend on the type of IRA, marital status and more.)

Maximum benefits

"People are very busy, they're working trying to make ends meet, so they don't have the time to really look into it," said Richard Hisey, chief investment officer for AARP Financial. "There are some nice tax advantages that average people are missing out on, where the only excuse for missing out is that they don't know ... because if you did know the advantages, you would want to take them."

Hisey noted that it's not just IRAs that are underutilized, but also the "saver's tax credit," which is available to people who contribute to their employer-sponsored retirement plans or into IRAs. The credit -- which applies to low-income singles (up to $26,000 in adjusted gross income for 2007) and couples ($52,000) -- can help ease the burden of saving in the first place.

"And then there's the economic stimulus package, which is money people didn't otherwise expect that could be used to start an IRA, and you have a lot of ways to get a head start right now," says Hisey.

Of course, the flip side to finding ways to save is working more. An early February survey from AXA Equitable suggested that Americans have a poor outlook when it comes to their retirement security; while 80% of Americans said they had begun to prepare for retirement -- starting on average at age 30 -- they did not anticipate being able to retire until they hit age 64, a full six years beyond their ideal retirement age.

Some 85% of the working people surveyed expect their standard of living to remain the same or decline in retirement -- a reality that four out of five retirees surveyed said they are living with.

"All of the studies show that people aren't saving enough and aren't excited about the future," Slott said, "but then you get other studies which say that people don't know how to save. If you know that you need to save, and you don't know the rules about IRAs, then you know it's time to figure out what you can to save -- not to wait and hope you will figure it out."

Chuck
Jaffe

Chuck Jaffe is a nationally syndicated financial columnist. Follow him on Twitter @ChuckJaffe.

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